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In San Francisco, a Swaps Success Story

It's easy to forget amid the sea of scandal and outrage that has roiled the municipal-bond market this year, but interest-rate swaps aren't bad for everybody.

The most common interest-rate swaps, where bond issuers agree to pay a bank a fixed interest rate in return for the bank covering payments on variable-rate bonds, were big winners for some prudent players in the municipal-bond market.

Take, for example, San Francisco International Airport, or SFO. The airport's head of capital finance, Kevin Kone, said swaps have allowed SFO to cut its debt service to 44% of operating costs from 50% in the last six years.

That, in turn, has driven down the airport's cost per passenger boarding a plane by 31% to $13.48, and allowed it to attract new, low-cost carriers.

"It has served the airport well," Mr. Kone said. "It has been a way to create certainty in a less certain environment."

That is the theory, anyway. Interest-rate swaps are a way to lock in low rates by exchanging cheap, but risky, variable-rate interest payments for a substantially reduced fixed rate.

Of course, that's not always the case. Reduced costs come with a myriad of new risks, as bond issuers from Harvard University to Jefferson County, Ala., have discovered the hard way. From the most sophisticated borrowers to the least, even the simplest swaps have proven a tricky financing problem, and one that can leave taxpayers out hundreds of millions of dollars. Given that reality, it may be useful to look at what SFO did right.

The first lesson, according to Mr. Kone, is avoid bankers bearing leading-edge financial engineering. Mr. Kone said that at the height of the financial boom, investment banks were pitching municipalities "hot and heavy" on new contracts that would cut their cost of capital. While the airport saw the advantages of some contracts, they drew a firm line in the sand: understandability.

As a result, the airport chose only the plainest of "plain vanilla" swaps. Under the contracts they issue variable-rate bonds, and the bank pays the interest on those bonds in return for a steady fixed-rate interest payment.

From the bank's perspective, the contract is a speculative bet that interest rates will remain below the fixed rate -- 3.95% in the contracts SFO has coming into effect in February with
Goldman Sachs Group Inc.
GS 1.19%
and the Irish bank DePfa Bank PLC. But for SFO, it locks in low interest rates on long-term debt.

The second lesson is to recognize that even if it saves some money, a swap agreement adds players, and risks, to a debt offering. SFO took the time to hold public hearings that outline all of the various risks a swap exposed them to, including the risk that the bank they entered into the agreement with could fail, leaving them exposed. They also resolved that because of those risks, they would only enter into swaps that saved the airport significant amounts of money.

"If you enter into a swap where you save a dollar, you're only saving a dollar but you got a ton of risk," Mr. Kone said. "The amount of money you save ... needs to be commensurate with what you think is worth the risk."

Incidentally, Mr. Kone doesn't think the risks are worth the payoff right now, since the credit crisis has considerably driven up the cost of swaps. He said the swaps going into effect in February will be the airport's last for the foreseeable future.